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CEO Compensation and Company Performance - An Open Letter to the CEO

Dear CEO:

The purpose of this letter is to provide you with the benefit of my observations over the past few years with the hope that it will help in your efforts to move the company forward. These observations are blunt and intended to inform, not to offend. Specifically, my hope is that they will help you understand the negative impact that your compensation is having on the organization, and ultimately, the success of your company. But before continuing, let me introduce myself. I'm Ron Moore, a middle manager and one of your most loyal and longtime employees. I've served the company for the past thirty years, but will be retiring next week. Before leaving, however, I wanted to share these observations, which are typical of most all my peers and subordinates, and indeed the majority of your employees.

While we think you've done an OK job, perhaps a C+ or B- overall, we don't think that you deserve the millions that have been showered upon you for what amounts to mediocre performance. Our company's profit over the past several years has been near our industry average, likewise for our return on capital and revenue growth. We currently have no new "blockbuster" products pending that I know of. In fact, we've been concerned for years now about how little we've spent on R&D for new products and processes; on our marketing and distribution systems; and particularly, on maintenance in our manufacturing plants. Even more troubling is that these modest profits seem to have been achieved only because of the company's short-term cost-cutting in these areas, putting the future of the company at risk. Perhaps you'll be gone by the time these effects are realized, but in the meantime, you certainly do talk a good game. Your eloquence is mesmerizing at times, but given the company's performance compared to your pay, it's not clear whether you're dazzling us with brilliance or baffling us with bullstuff

Let 's be clear. We believe you deserve to be paid handsomely. But did you know that you've received pay raises of 10% to 25% per year over the past five years, but we folks doing the work of keeping the company running have received 3% to 4%? Or, did you know that your pay over the past several years has been some 400 times that of our average hourly employee? That's up from 40 times the average some 30 years ago. Imagine - you could have saved 300 jobs by receiving a mere 100 times that of the average worker. It feels like we do the work and you get the money. Somehow that doesn't seem fair, nor does it align our interests with company interests. Quite the contrary. There's just something wrong about this - you are getting a huge payout at the expense of your employees, particularly those who have been laid off. It's demoralizing. Many of us (not me, I'm retiring) spend our time worrying about whether we're next to be laid off, as opposed to looking for ways to help the company do better. Did you know that we surveyed fifty of my peers last year regarding your pay? It revealed that middle managers were resentful of what they considered your excessive pay. While they were committed to their jobs, they were not committed to the company, nor fully engaged in executing your strategy. It gets even worse when you talk to the union leadership. They're questioning giving up benefits and pay when you're being rewarded excessively at their expense; and they're questioning improving productivity only to see jobs going overseas, or simply going away. Something is wrong when regular payrolls are skinny and your pay is obese. This situation makes your strategy untenable and puts the company's future at risk, notwithstanding how eloquently you present it.

Now, just so you feel better about all this, your situation is much like most of the Fortune 500 companies. There are numerous studies (I've read several personally) that show there is no correlation between CEO pay and company performance. One study found that over a fiveyear period, top executive pay increased by 77%, while earnings growth increased by only 17%. Your pay mirrors this performance. How would you feel if we expected huge annual pay raises for performance like that?

We understand that there are a lot of very intelligent people, including your board of directors, who rationalize your pay with certain arguments. By the way, Merriam-Webster says that to rationalize is "to attempt to justify behavior normally considered irrational or unacceptable by offering an apparently reasonable explanation." That describes our observations of your pay, which seems irrational and unacceptable, in spite of the efforts of your board to rationalize it.

One rationale that is often used to justify CEO pay is the sports star analogy. That is, sports stars command huge salaries commensurate with what the market will bear. So, too, the argument goes, should CEOs. This argument is faulty. Sports stars don't have thousands working for them or people who look to them as a role model for leadership, and fairness! Sports stars focus on their personal success more so than the team's, often with egomaniacal behavior. Is this the model you want to emulate? Is this the model of behavior that will inspire your employees to make the company successful? Hardly. We believe that you have a fiduciary duty to put the needs of the company above your personal needs; and that you must lead by example, one that creates a sense of fairness, alignment and teamwork within the company. You currently do not.

Another rationale is the competitive parity argument. Unfortunately, all CEO compensation over the past two or three decades has been rising sharply, with each successive CEO chasing ever-increasing compensation packages using peer averages that have been climbing 10% per year while corporate profits have grown only modestly. If you listen to Prairie Home Companion, you'll recognize this as the Lake Wobegon effect, where everyone is above average. It's a statistical impossibility.

So, what should you do? We think you should use the principle that compensation must be "internally equitable and externally competitive" as a basis for developing policies and guidelines for executive pay. This simple principle is discussed below.

Internal equitability has to do with the perception that compensation is fair. If pay isn't perceived as internally equitable, morale and motivation will deteriorate and affect company performance, as demonstrated by the survey of fifty middle managers. We understand that totally eliminating any sense of inequity is highly unlikely, but having a clear policy that provides a transparent, well-communicated approach to compensation will help. You currently do not.

The vast majority of individuals expect that people of higher rank, authority, or responsibility will be paid more. How much more? Dr. W. Edward Deming suggested that once the CEO's compensation goes beyond about 20 times the wage of the average employee, a sense of inequity prevails. Warren E. Buffett has called executive pay the acid test of governance and "...often tells corporate chiefs to end practices ranging from huge CEO pay to incomprehensible financial reports." That's because the higher the gap between CEO pay and the regular worker, the greater the sense of inequity that's likely, therefore reducing morale and productivity. And, the greater the inequity, the more militant unions will be. This inequity is a huge distraction from the success of your company.

As a matter of policy, we believe you and your board of directors should follow the principle of internal equity and external competitiveness, applying the following in setting your compensation:

Overall industry performance must be used effectively as a normalizing factor. As the old saying goes, "Everyone's boat rises in a rising tide." Current policy ignores this. If the company's industry shows strong annual growth, return on equity, profits, etc., and the company is performing near the industry's average, then your pay should reflect average performance.

Strategic issues, and your pay, should relate to the company's success in three, five and ten years. Being strategic relates to your ability to understand the consequences of your decisions over the time frame associated with your level of responsibility. Incentivizing you with huge pay packages and stock options that vest in one or two years is not being strategic at your level of responsibility.

The concept of being strategic also requires fairness. Our annual results have been at the expense of reduced R&D and marketing, layoffs, low pay increases and longer hours for the people who do the day-to-day work to make the company successful, and you wealthier. These create a perception of unfairness, or inequity in the compensation system. If executive salaries are seen to reflect greed and abuse of power, an atmosphere is created where lower productivity, tweaking of expenses and other less than honest practices become common. It currently does.

Finally, as the lead representative of shareholders, you have an inherent fiduciary duty to lead the company in achieving a high level of performance, long term. You should not be paid extravagantly for doing the job you were hired to do. How would you respond to employees demanding significantly higher pay, year after year, for doing what they were hired to do?

In closing, we understand that in a global, capitalistic economy, the intense competition for survival and prosperity dictates that wages be constrained, including yours, and that productivity improvement be substantially greater than wage and cost increases to assure a continued competitive position. Those situations that lead to a dysfunctional and unsustainable outcome, i.e., extravagant pay for one person in an organization at the perceived expense of all others, must be avoided. Adam Smith, the father of free market thinking, believed that free markets also required sympathy, or caring for others and sharing the gains, and without that there would be a breakdown of the trust on which the market depends for its healthy operation. Moreover, Darwinian thinking is associated with the processes that create self-sustaining ecological systems, not simply the survival of the powerful for a brief period. Think of this as having equity and fairness in the pay structure so that the business system has a greater probability for survival and sustainability.

We believe that you have a fiduciary duty to diligently work toward the best interests of the company in applying these principles. How can we be a high performance organization if 99% of the people don't believe they share equitably in the success of the company? It's your responsibility to assure that they do.

We hope this has been thought provoking and that you will take appropriate action to address this issue. The company and its employees deserve no less.

Ron Moore

Ron Moore is the Managing Partner of The RM Group, Inc. He is the author of Making Common Sense Common Practice: Models for Manufacturing Excellence, and of Selecting the Right Manufacturing Improvement Tools: What Tool? When?

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